Top

Review of Accounting Studies

Published in:

01-12-2008

Rewriting earnings history

Authors: Baruch Lev, Stephen G. Ryan, Min Wu

Published in: Review of Accounting Studies | Issue 4/2008

Activate our intelligent search to find suitable subject content or patents.

search-config

AI-assisted search

Off

Abstract

Research on the usefulness of financial information generally focuses on the innovation in the information examined, such as an earnings surprise or cash flow growth. Consequently, prior research sheds little light on the role of the rich historical record of financial information in users’ decision-making. Using a sample of published restatements of earnings, we show that the revision of the historical pattern of earnings, distinct from the magnitude of the restatement and its impact on current earnings, significantly affects investors’ decisions and predicts class action lawsuits. Specifically, we find that restatements that eliminate or shorten histories of earnings growth or positive earnings have significantly more adverse effects for investor valuations and the likelihood of lawsuits than other restatements. This evidence about the value-relevance of refreshing the historical record of earnings is pertinent to the FASB’s recent cautious expansion of the scope of circumstances that require a restatement of financial information in FAS 154.

next article Tax incentives for inefficient executive pay and reward for luck

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

There are a few other cases where firms are required to disclose revisions of historical records. For example, FAS 146 requires firms to disclose revisions of liabilities accrued for exit or disposal activities.

This may be attributable in part to findings (for example, Ball & Watts, 1972) that earnings tend to follow a random walk, although Brooks and Buckmaster (1980) report that this is not the case for firms with large absolute earnings changes. We discuss the issue of earnings following a random walk in more detail in Sect. 4.

There are, of course, exceptions to this statement, such as Barth, Elliott, and Finn (1999).

For elaboration on the role of historical context in general in understanding and interpreting current events, see Howard (1991, Ch. 1).

See, for example, Mankiw and Shapiro (1986) and Diebold and Rudenbusch (1991).

A literature similarly motivated to that of earnings restatements examines property-casualty insurers’ loss reserve development disclosures. Under the Securities and Exchange Commission’s Exchange Act Industry Guide 4, property-casualty insurers are required annually to update prior estimates of their claim loss reserves for each prior accident year’s coverage. This literature documents that loss reserves are estimated with discretion (e.g., loss reserve revisions are negatively correlated with insurer solvency and positively serially correlated) and that upward loss reserve revisions have negative implications for insurers’ market value, risk, and future profitability. See Petroni (1992), Beaver and McNichols (1998, 2001), and Petroni, Ryan, and Wahlen (2000).

Feroz et al. (1991) and Dechow et al. (1996) find similar negative market reactions at the announcement of SEC enforcement actions.

In a specification test, Palmrose et al. (2004) replace the magnitude of the restatement with an indicator variable for restatements that decrease current income and the absolute value of the change in net income. They find that the coefficients on both variables are significantly negative.

While it may seem surprising that the market reacts less adversely to SEC-enforced earnings restatements, this finding may reflect the fact that these restatements often result from the SEC’s desire to change a general accounting practices (e.g., in-process research and development) which affects multiple firms. To the extent that more firms make these restatements, they appear to reflect less negatively on any given restating firm.

Palmrose et al. (2004), Anderson and Yohn (2002), and Wu (2003) include numerous control variables in their returns regression models, which they find (and in supplemental analysis we confirm) to be insignificant. Of particular note, Wu finds that the coefficient on an indicator variable for confounding significant disclosures or events in the restatement announcement window is insignificantly negative.

Dechow et al. (1996) conduct similar analyses and obtain similar findings for SEC enforcement actions.

Summers and Sweeney (1998) document similar stock sales by insiders before the revelation of fraud, as does Beneish (1999) before SEC enforcement actions.

Bonner et al. (1998) obtain similar results for the filing of lawsuits against the auditors of firms subject to SEC enforcement actions.

A related issue is that restatements of earnings, like all accrual adjustments, reverse over time. Sometimes these reversals are complete when restatements are announced (restatements that decrease earnings in certain periods and increase earnings by the same amount in other periods), and sometimes they are incomplete (e.g., restatements that only decrease earnings before announcement). Whether these reversals are complete has implications for the prediction of future earnings and so may affect returns or the likelihood of class action lawsuits differently (e.g., investors may not be fully aware of the future reversals in the second type of restatements, above). We do not explore this issue.

Most of this sample was collected by Wu (2003), excluding her restatements of previously announced unofficial results. We extended her sample forward in time by collecting 83 additional restatements in 2001 and 2002. We also augmented her data with annual earnings data for nonrestated fiscal years (which we use to construct our measures of earnings history), which we collected from Compustat (data item 172), and stock returns data, which we retrieved from CRSP.

The number of restatements continues to increase. According to Huron Consulting Group (quoted in Bryan, Lilien, Ruland, & Sinnett, 2005), there were 323 restatements in 2003 and 414 in 2004. Jeff Szafran, Huron’s managing director, attributes the 2004 increase to the “unprecedented level of regulatory and audit scrutiny, driven primarily by the Sarbanes-Oxley Act of 2002.” Glass Lewis & Co. reports 1,195 restatements by U.S. firms in 2005.

Currentmag takes a nonzero value for 606 observations. Laggedmag takes a nonzero value for 389 observations, of which 224 involve nonzero restatements of earnings in one prior year, 106 in two prior years, 43 in three prior years, 12 in four prior years, and four in five prior years.

This is the case in our hypothetical example above. The most recent restatement was for the first two quarters of 1998, which we treat as a fiscal year.

In calculating undoearngrow and undoearnpos, we examined histories or earnings up to 7 years before the most recent fiscal year restated. Of the 821 restatement observations, nine have continuous histories of earnings growth of 7 years or more, five of which were eliminated by the restatement, while 130 observations have continuous histories of positive earnings of 7 years or more, 22 of which were eliminated by the restatement. Undoearngrow and undoearnpos can take values of one because of any year that is both involved in the restatement and part of the prior history of earnings growth or positive earnings, respectively.

Both undoearngrow and undoearnpos take values of one for 48 (6 percent) of the observations.

Given the size of our sample, we chose 4 years as the cutoff for grow4 and pos4 in an attempt to obtain a sufficient number of observations with a substantial history of earnings growth or positive earnings. The use of longer histories of earnings growth or positive earnings (e.g., the 5-year history examined by Barth et al., 1999) reduces the number of observations with such histories significantly, especially for earnings growth, whereas shorter histories provide less contrast with our primary variables.

Wu (2003) classifies the primary reason for/line items affected by the restatement into nine categories: (1) both revenue and operating expenses, (2) revenue only, (3) operating expenses only, (4) loan loss allowances, (5) mergers and acquisitions, (6) in-process research and development, (7) reclassification, (8) errors, and (9) other. We include categories 1 and 2 in our indicator variable revenue.

See note 14.

For example, this conjecture is consistent with Burgstahler and Dichev (1997) and Dechow, Richardson, and Tuna’s (2003) findings that firms with (even slightly) positive earnings have greater cash flow and various other indicators of solvency than do firms with (even slightly) negative earnings. Moreover, we determined that 40 (4.9 percent) of the firms in our sample declared bankruptcy in the year following the restatement announcement, and that firms with pos4 = 0 are 50 percent more likely to go bankrupt in the year following the restatement than are firms with pos4 = 1 (5.7 percent versus 3.8 percent, respectively).

While we predict and find that the intercept is negative in the return analysis, we make no prediction about the intercept in the logit estimation of Eq. (3), because the estimated intercept adjusts to yield the sample average probability of a class action lawsuit, given the means of and estimated slope coefficients on the explanatory variables in Eq. (3).

Accounting Principles Board (APB). Opinion No. 20. (1971). Accounting changes. New York, NY: APB.

Agrawal, A., & Chadha, S. (2005). Corporate governance and accounting scandals. Journal of Law and Economics, 48, 371–406.CrossRef

Anderson, K., & Yohn, T. (2002). The effect of 10-K restatements on firm value, information asymmetries, and investors’ reliance on earnings. Working paper, Georgetown University, Washington, D.C.

Antle, R., Demski J., & Ryan S. (1994). Multiple sources of information, valuation, and accounting earnings. Journal of Accounting, Auditing & Finance, 9, 675–696.

Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research, 6, 159–178.CrossRef

Ball, R., & Watts, R. (1972). Some time-series properties of accounting income. Journal of Finance, 27, 663–681.CrossRef

Banyi, M. (2006). An Evaluation of the causes and consequences of in-process research and development restatements. Working paper, Oregon State University, Corvalis, OR.

Brooks, L., & Buckmaster, D. (1980). First-difference signals and accounting income time-series properties. Journal of Business, Finance, and Accounting, 7, 437–454.CrossRef

Barth, M., Elliott J., & Finn, M. (1999). Market rewards associated with patterns of increasing earnings. Journal of Accounting Research, 37, 387–413.CrossRef

Beaver, W., & McNichols, M. (1998). The characteristics and valuation of loss reserves in the property and casualty insurance industry. Review of Accounting Studies, 3, 73–95.CrossRef

Beaver, W., & McNichols, M. (2001). Do stock prices of property casualty insurers fully reflect information about earnings, cash flows, and development. Review of Accounting Studies, 6, 197–200.CrossRef

Beneish, M. (1999). Incentives and penalties related to earnings overstatements that violate GAAP. The Accounting Review, 74, 425–457.CrossRef

Bonner, S., Palmrose, Z., & Young, M. (1998). Fraud type and auditor litigation: An analysis of SEC accounting and auditing enforcement releases. The Accounting Review, 73, 503–532.

Bryan, S., Lilien, S., Ruland, W., & Sinnett, W. (2005). Undoing the past: Implications of earnings restatements. Financial Executive, 21, 42–44.

Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24, 99–126.CrossRef

Burns, N., & Kedia, S. (2004). The impact of performance-based compensation on misreporting. Working paper, University of Georgia, Athens, GA.

Callen, J., Robb, S., & Segal, D. (2003). Revenue manipulation and restatements by loss firms. Working paper, University of Toronto, ON, Canada.

Dechow, P., Sloan, R., & Sweeney, A. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13, 1–36.CrossRef

Dechow, P., Richardson, S., & Tuna, I. (2003). Why are earnings kinky? An examination of the earnings management explanation. Review of Accounting Studies, 8, 355–384.CrossRef

Desai, H., Hogan, C., & Wilkins, M. (2006). The reputational penalty for aggressive accounting: Earnings restatements and management turnover. The Accounting Review, 81, 83–112.CrossRef

Defond, M., & Jiambalvo, J. (1991). Incidence and circumstances of accounting errors. The Accounting Review, 66, 643–655.

Diebold, F., & Rudebusch, G. (1991). Forecasting output with the composite leasing index: A real-time analysis. Journal of the American Statistical Association, 86, 603–610.CrossRef

Dowdell, T., & Press, E. (2001). Restatement of in-process research and development write-offs: The impact of SEC scrutiny. Working paper, Temple University, Philadelphia, PA.

Feroz, E., Park, K., & Pastena, V. (1991). The financial and market effects of the SEC’s accounting and auditing enforcement releases. Journal of Accounting Research, 29(Supplement), 107–142.CrossRef

Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 16. (1977). Prior period adjustments. Norwalk, CT: FASB.

Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 146. (2002). Accounting for costs associated with exit or disposal activities. Norwalk, CT: FASB.

Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 154. (2005). Accounting changes and error corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3. Norwalk, CT: FASB.

Glass Lewis & Co. (2006). Restatements trend alert. Getting it wrong the first time. San Francisco, CA: Glass Lewis & Co.

Griffin, P. (2003). A league of their own? Financial analysts’ responses to restatements and corrective disclosures. Journal of Accounting, Auditing, & Finance, 18, 479–528.

Grundfest, J., & Perino, M. (1997). Securities litigation reform: The first year’s experience. Working paper, Stanford University, Palo Alto, CA.

Howard, M. (1991). The Lessons of History. New Haven and London: Yale University Press.

Hribar, P., & Jenkins, N. (2004). The effect of accounting restatements on earnings revisions and the estimated cost of capital. Review of Accounting Studies, 9, 337–356.CrossRef

Kedia, S., & Philippon, T. (2006). The economics of fraudulent accounting. Working paper, Rutgers University, Newark, NJ.

Khan, M. (2005). Are accruals really mispriced? Evidence from tests of an intertemporal capital asset pricing model. Working paper, University of Toronto, ON, Canada.

Kinney, W., & McDaniel, L. (1989). Characteristics of firms correcting previously reported quarterly earnings. Journal of Accounting and Economics, 11, 71–93.CrossRef

Kravet, T., & Shevlin, T. (2006). Accounting restatements and information risk. Working paper, University of Washington, Seattle, WA.

Lev, B. (2003). Corporate earnings: Facts and fiction. Journal of Economic Perspectives, 17, 27–50.CrossRef

Lu, Y. (2003). Earnings management and securities ligitation. Working paper, Stanford University, Stanford, CA.

Lundholm, R. (1999). Reporting on the past: A new approach to improving accounting today. Accounting Horizons, 13, 315–323.CrossRef

Lundholm, R. (2003). Historical accounting and the endogenous credibility of current disclosures. Journal of Accounting, Auditing & Finance, 18, 207–229.

Mankiw, G., & Shapiro, M. (1986). News or noise: An analysis of GNP revisions. Survey of Current Business, 66, 20–25.

Myers, J., & Skinner, D. (2002). Earnings momentum and earnings management. Working paper, University of Michigan, Ann Arbor, MI.

Myers, J., Myers, L., Palmrose, Z., & Scholz, S. (2004). Mandatory auditor rotation: Evidence from restatements. Working paper, University of Illinois at Urbana-Champaign, IL.

Palmrose, Z., Richardson, V., & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting & Economics, 37, 59–89.CrossRef

Palmrose, Z., & Scholz, S. (2004). The circumstances and legal consequences of non-GAAP reporting: Evidence from restatements. Contemporary Accounting Research, 21, 139–180.CrossRef

Petroni, K. (1992). Optimistic reporting in the property-casualty insurance industry. Journal of Accounting and Economics, 15, 485–508.CrossRef

Petroni, K., Ryan, S., & Wahlen, J. (2000). Discretionary and non-discretionary revisions of loss reserves by property-casualty insurers: Differential implications for future profitability, risk, and market value. Review of Accounting Studies, 5, 95–125.CrossRef

Richardson, S., Tuna, I., & Wu, M. (2003). Capital market pressures and earnings management: The case of earnings restatements. Working paper, University of Pennsylvania, Philadelphia, PA.

Ryan, S. (1997). A survey of research relating accounting numbers to systematic equity risk, with implications for risk disclosure policy and future research. Accounting Horizons, 11, 82–95.

Skinner, D., & Sloan, R. (2002). Earnings surprises, growth expectations, and stock returns. Review of Accounting Studies, 7, 289–312.CrossRef

Summers, S., & Sweeney, J. (1998). Fraudulently misstated financial statements and insider trading: An empirical analysis. The Accounting Review, 73, 131–146.

United States General Accounting Office. (2002). Financial statement restatements: Trends, market impacts, regulatory responses, and remaining challenges. GAO-03-138. Washington, DC: GAO.

Wu, M. (2003). Earnings restatements: A capital markets perspective. Working paper, Hong Kong University of Science and Technology, Hong Kong.

Title: Rewriting earnings history
Authors: Baruch Lev
Stephen G. Ryan
Min Wu
Publication date: 01-12-2008
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 4/2008
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-007-9041-4

Springer Professional

Abstract

Please log in to get access to your license.

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Other articles of this Issue 4/2008

Tax incentives for inefficient executive pay and reward for luck

Does acquirer cash level predict post-acquisition returns?

Are executive stock option exercises driven by private information?

The relevance of quantifiable audit qualifications in the valuation of IPOs

Investor reactions to derivative use and outcomes